FIN 40500: International
Finance
Forwards, Futures and Options
Derivative Securities vs. Stocks/Bonds
Stocks and Bonds
represent claims to
specific future cash
flows
Derivative securities
on the other hand
represent contracts
that designate future
transactions
Currently, there are approximately 300 million derivative
contracts outstanding with a market value of around $50 Trillion!!!
Derivative securities can be used for hedging or for speculation
Porsche expects $12.5M in
US sales over the next month
that that it would like to
repatriate back to Germany
Mercedes need to acquire
$12.5M to meet its payroll for
its Tuscaloosa, Alabama plant
Porsche is worried that the
dollar might depreciate over
the next month
Mercedes is worried that the
dollar might appreciate over
the next month
Both Porsche and Mercedes could avoid their potential
currency risk by entering into a forward contract.
Forward contracts are individualized contracts to buy/sell a currency at a
pre-specified date and for a pre-specified price.
Deutsche
Bank
Porsche
approaches
Deutsche
Bank with an
offer to buy
Euro 30 days
forward
Deutsche Bank
negotiates a
price of $1.25
per Euro
In 30 days, Porsche will
buy 10 Million Euro from
Mercedes for $12.5M
Mercedes
approaches
Deutsche
Bank with an
offer to sell
Euro 30 days
forward
On Settlement day, Porsche delivers its $12.5M and acquires 10M
Euro. Had it instead bought Euro in the spot market, It would’ve
needed $12.9M to buy 10M Euro – Porsche “gains” $400,000
1.295
1.29
e = 1.29
EUR/USD
1.285
1.28
F = 1.25
1.275
1.27
1.265
1.26
1.255
0
4
8
12
Days 15
18
23
27
Note that Mercedes has an equal “loss” of $400,000
Forward contracts are available on all
the major currencies
Spot
33%
EUR/USD
1 month
3 months
6 months
12 months
1.2762
1.2786
1.2836
1.2905
1.3026
Futures
56%
The published prices are not
actual contract prices but the
average of contracts made at
major banks.
Forward
11%
In 1972, the Chicago Mercantile Exchange began trading
currency Futures. By 2004, the number of currency
futures outstanding stood at 48M with a value of
approximately $5T!!
Futures are standardized (size and maturity), exchange traded
commodities
Currency futures trade in a March, June,
September, December expiration cycle –
Delivery is made on the 3rd Wednesday of the
month and the contracts are traded up to two
days prior to delivery.
Jan
Mar
June
Sept.
Dec.
Futures are available for a wide range of commodities and assets
Currencies
Agriculture
Metals &
Energy
Financial
British Pound
Lumber
Copper
Treasuries
Euro
Milk
Gold
LIBOR
Japanese Yen
Cocoa
Silver
Municipal Index
Canadian Dollar
Coffee
Platinum
S&P 500
Mexican Peso
Sugar
Oil
DJIA
Cotton
Natural Gas
Nikkei
Wheat
Cattle
Soybeans
Eurodollar
Currency
Contract Size
Australian Dollar
AUD 100,000
Brazilian Real
BRR 100,000
British Pound
GBP 62,500
Canadian Dollar
CAD 100,000
Czech Koruna
CZK 4,000,000
Euro
EUR 125,000
Hungarian Forint
HUF 30,000,000
Japanese Yen
JPY 12,500,000
Mexican Peso
MXN 500,000
New Zealand Dollar
NZD 100,000
Norwegian Krone
NKR 2,000,000
Polish Zlotny
PLZ 500,000
Russian Ruble
RUB 2,500,000
South African Rand
ZAR 500,000
Swiss Franc
CHF 125,000
There are also cross rate futures traded (EUR/GBP, EUR/JPY, and
EUR/CHF) in contract sizes of EUR 125,000
Futures are standardized (size and maturity), exchange traded
commodities (Chicago Mercantile Exchange)
EUR 125,000
Total Contracts bought/sold
that day (000s)
Opening, High, Low,
and Closing Price
Strike
Open
High
Low
Settle
Pt
Chge
Volume
Interest
Mar06
1.2700
1.2804
1.2698
1.2756
+170
3500
8993
Jun06
1.2850
1.2987
1.2800
1.2799
-150
3
34
------
------
------
Sept06
Settlement Date
-----
UNCH
Change From Prior Day (in Pips)
-----
-----
Contracts Outstanding
(000s)
Chicago
Mercantile
Exchange
Porsche
goes long
on 80 Euro
contracts
The CME simultaneously
buys 80 contracts from
Mercedes and sells 80
contracts to Porsche
Mercedes
goes short
on 80 Euro
contracts
From the previous example, if Porsche is buying 10M Euro, it would
need to purchase 80 Euro futures contracts (125,000 x 80 = 10M )
Futures contracts are marked to market daily. That is, profits and losses
are kept track of on a daily basis.
Suppose that Porsche goes long on 80 Euro contracts at
a price of $1.25 per Euro – The total cost of the contract
is $12.5M
Porsche is required to deposit an initial performance bond equal
to 2% of the contract value – this can be in the form of cash or a
Treasury bill.
2% of $12.5M = $250,000
May 1
June 21
Delivery Date
On May 1, Porsche deposited $250,000 worth of Treasury
Bills into its maintenance account.
On May 2, the closing price for June Euro futures is
$1.27. Porsche’s profit on its contract is $200,000. This is
deposited into Porsche’s maintenance account ($450,000
balance).
On May 3, the closing price for June Euro futures
is $1.24. Porsche’s one day loss on its contract is
$300,000. This is withdrawn from Porsche’s
maintenance account ($150,000 balance).
May 1
May 2
May 3
June 21
Delivery Date
When your maintenance account drops below 75% of its original
value, you must add to it!!
While the overwhelming majority (90%) of forward contracts end with
actual delivery of the currency, very few futures contracts (1%) result in
delivery.
Suppose that on June 3, Porsche wishes to end its futures
contract. Suppose that the current price of a June Euro future
is $1.28
Porsche goes short on 80 June Euro
futures at a price of $1.28. The two
contracts offset one another and
Porsche goes home with its profit of
$300,000
May 1
F = $1.25/Euro
June 3
June 21
Delivery Date
Essentially, futures positions are making “bets”
on the price of the underlying commodity.
Long Position
Profits from
price increases
Short Position
Profits from price
decreases
Treasury futures first began trading on the CME in 1976. The
underlying commodity is a $1M Treasury Bill with 90 days to maturity.
Remember, when interest rates rise, Treasury prices fall!
 FV  P  360 
DY  

100
 FV  n 
Long Position
Profits from
price
increases
Profits from
decreasing
interest rates
Short Position
Profits from
price
decreases
Profits from
increasing
interest rates
T-Bill futures are listed using the IMM (International
Monetary Market) Index
IMM = 100 – Annualized Discount Yield
For example, if the Price of a $100, 90 Day Treasury were $98.
 $100  $98  360 
DY  

100  8%
100

 90 
IMM = 100 – 8 = 92
Note that Every .01 increase in the IMM raises the value of a
long T-Bill position by $25 (per basis point).
Eurodollar futures were introduced in 1981 as an alternative to
Treasury futures.


The underlying commodity is a $1M, 3 month Eurodollar time
deposit. However, these deposits are not marketable.
Therefore, Eurodollar futures are settled on a cash basis
Eurodollar futures can be treated like a T-Bill Future
IMM = 100 – Annualized LIBOR
Every .01 increase in the IMM raises the value of the long
position by $25 (per basis point)
Eurodollar Futures vs. T-Bill Futures
T-Bill Futures
Contract
Volume (2001)
123
Eurodollar
Futures
Contracts
730,000
As the Eurodollar market grew, it became more liquid
relative to the T-Bill market
LIBOR is a “risky” rate.
with other risks
Therefore, it correlates better
Suppose that you expect to receive $20M in June. You do not need
the $20M until September. The current 3 month LIBOR rate is 2.91%
(Annualized)
This $20M should be invested from June to September to earn interest,
but currently the interest rate from June to September is uncertain.
June Eurodollar futures are currently trading at 96.56
IMM = 96.56
LIBOR = 2.91%
May 1
$20M
received
June
$20M
needed
September
The June Eurodollar futures with a 96.56 price implies an annualized
rate of return equal to 3.44% from June to September
You can “lock in” the 3.44% interest rate by taking a long position in
Eurodollar futures. Suppose that you purchase 20 Eurodollar
contracts at the current price of 96.56.
3.44%
IMM = 96.56
$20M
received
May 1
June
$20M
needed
September
Suppose that in June, the LIBOR rate is 3.10% Annualized.
You receive your $20M in June and deposit it in a
Eurodollar account at 3.1% (annual) interest. Your interest
earned well be $155,000 - $20M*(.031/4)
Your profit from the Future is (96.90-96.56)(100)($25)(20) = $17,000
Your total gain is $17,000 + $155,000 = $172,000
(3.44% Annualized return)
3.10%
You paid 96.56 per
contract in May (20
contracts)
May 1
IMM = 96.90
June
September
Unlike a future, an option gives the owner the right, but not the
obligation to buy or sell the underlying commodity.
Call Option
The owner (long position) on a call option has the right but not
the obligation to buy the underlying commodity at the
predetermined price
The seller (writer) of the call option has the obligation to sell the
underlying commodity if the option is exercised.
Put Option
The owner (long position) on a put option has the right but not
the obligation to sell the underlying commodity at the
predetermined price
The seller (writer) of the put option has the obligation to buy the
underlying commodity if the option is exercised.
The stated price that the underlying commodity is bought or sold at is
known as the strike price.
In December 1982, the Philadelphia Stock Exchange started
trading American and European options on foreign currency.
Can only be exercised at
maturity
Can be exercised at any time during the
life of the contract
Traded options have an expiration cycle March, June, September and
December with original maturities of 3,6,9,and 12 months.
Currency
Contract Size
Australian Dollar
AUD 50,000
British Pound
GBP 62,500
Canadian Dollar
CAD 50,000
Japanese Yen
JPY 6,250,000
Swiss Franc
CHF 62,500
Euro
EUR 62,500
At expiration, an American option and a European option that has not
been exercised will have the same terminal value.
Put option
Call option
C  max S  E,0
P  max E  S ,0
Exercise price of the option
contract
Spot price of the underlying asset
Remember, as the owner of the option, you will not exercise if it is
unprofitable!!
Suppose that you purchase a call option on Euro at an exercise
price of 130 ($1.30 per Euro). The standard Euro contract is 62,500
Euro.
Expiration Value
V  ($1.35  $1.30)(62,500)  $3,125
Spot Exchange
Rate
$1.30
$1.35
Here, the option is “out of the money”
and will not be exercised.
Note that the writer of the call has the opposite payout (as with
futures, this is a zero sum game)
Expiration Value
$1.30
$1.35
V  ($1.30  $1.35)(62,500)  $3,125
Spot Exchange
Rate
Options have a premium attached to them. This is the price that the buyer
pays for the option contract. Suppose that the premium on this Euro call is
4.59 cents per Euro (the option will cost .0459*62,500 = $2,868.75)
Expiration
Value
V  ($1.35  $1.30)(62,500)  2,868.75  $256.25
$1.3459
Spot
Exchange
Rate
-$2,868.75
$1.30
$1.35
Suppose that you purchase a put option on Euro at a strike price of
$1.30. The premium on this option is 3.50 cents per Euro
(.035*62,500 = $2,187.50)
Expiration
V  ($1.30  $1.25)(62,500)  $2,187.50  $937.50
Value
$1.2650
$1.30
$1.25
-$2,187.50
Spot
Exchange
Rate
The previous example dealt with “vanilla options”. There are many,
many more “exotic” options.
Bermuda Options: Can be exercised at various, predetermined dates
over the life of the contract
Asian Option: Also known as an average option – exercised at
maturity and the payoff is based on the average price of the underlying
commodity over the life of the contract.
Barrier options: The payoff is contingent on whether or not the
underlying commodity has reached a predetermined price
Compound Options: The underlying commodity is an option
Digital Option: Also known as a binary option – the payout is fixed
once the strike price has been reached.
You can also buy options on futures contracts.


Currency swaps are contracts to convert known income/payment
streams from one currency to another – think of them as a
portfolio of forwards with varying maturities/strikes
As with forward contracts, swaps are individualized and not
traded.
Suppose that IBM wishes to raise funds by issuing a 5 year Swiss
Franc denominated Eurobond with a face value of CHF 100,000
and fixed annual coupon payments of 6%. Up front, IBM receives
CHF 100,000. IBM plans on using the proceeds to finance
domestic operations
0 Yrs
1 Yrs
2 Yrs
3 Yrs
IBM owes
CHF 6,000
IBM owes
CHF 6,000
IBM owes
CHF 6,000
IBM Collects CHF
100,000
4 Yrs
5 Yrs
IBM owes
CHF 6,000
IBM owes
106,000
IBM Wishes to hedge
its currency exposure
CHF
IBM enters into a swap
agreement with
0 Yrs
IBM Sells
CHF
100,000
@ .844
1 Yrs
2 Yrs
3 Yrs
IBM buys
CHF 6,000
@ .845
IBM buys
CHF 6,000
@ .830
IBM buys
CHF 6,000
@ .800
4 Yrs
5 Yrs
IBM buys
CHF 6,000
@ .840
IBM buys CHF
106,000
@ .836
This swap is very similar to buying/selling six separate futures
contracts and is priced in a similar fashion
The Bottom Line…
There is a virtually endless set of options
(pardon the pun) for hedging currency exposure.
However, your ability to effectively and efficiently
hedge depends on your understanding of the
specific exposure that you face!!